04/06/2012

"A Look at Credit Default Swaps and Their Impact on the European Debt Crisis"

The Regional Economist: ...CDS spreads are an important metric of default risk—a higher spread on the CDS implies a greater risk of default by the reference entity. This feature can provide useful information as to how financial markets perceive the risk of default on corporate and sovereign debt. To illustrate this phenomenon, we study changes in the CDS spreads on the debt of European nations over the past few years. Figure 1 illustrates spreads on five-year CDS in Europe since 2005. Each series is an equally weighted index of country groupings where data are available—distressed countries in the eurozone (European Union members that use the euro as their currency), other countries in the eurozone, Western European countries that do not use the euro as currency and Eastern European countries that do not use the euro as currency. Prior to the crisis, CDS spreads were low for all of the reference countries, showing that investors placed low probabilities on these countries defaulting on their debts.

The onset of the financial crisis in 2008 raised the CDS spreads for all of the sampled groups of countries, especially for those in Eastern Europe. At the time, it was believed that Eastern European countries relied heavily on foreign capital flows to roll over their debt obligations. The Russian default in the late 1990s had made investors wary of the ability of these countries to service their debts in the face of a global downturn. In fact, many of the countries on the list solicited emergency loans from the International Monetary Fund.

Since the crisis, it is clear that investors have become increasingly wary of the distressed eurozone countries. Their CDS spreads have continued to rise, reaching newer highs each quarter. These countries have relatively elevated debt levels, and investors have little faith in the countries' abilities to service their debt obligations. Although the CDS spread on these countries as a group was lower than that of their Eastern European peers initially, subsequent events have raised the spreads on the distressed countries' debt well beyond those for Eastern Europe.

Also notable is the fact that spreads on the nondistressed eurozone and Western European countries were initially elevated but then fell, reflecting that these countries were viewed after the crisis as fiscally sound. However, in the past few months, the fact that these spreads have continued to rise does not bode well for these countries in particular and the European region as a whole. More recently, although the spreads have receded from recent highs, investors' concerns about European debt continue to persist.

Comments

The Regional Economist: ...CDS spreads are an important metric of default risk—a higher spread on the CDS implies a greater risk of default by the reference entity. This feature can provide useful information as to how financial markets perceive the risk of default on corporate and sovereign debt. To illustrate this phenomenon, we study changes in the CDS spreads on the debt of European nations over the past few years. Figure 1 illustrates spreads on five-year CDS in Europe since 2005. Each series is an equally weighted index of country groupings where data are available—distressed countries in the eurozone (European Union members that use the euro as their currency), other countries in the eurozone, Western European countries that do not use the euro as currency and Eastern European countries that do not use the euro as currency. Prior to the crisis, CDS spreads were low for all of the reference countries, showing that investors placed low probabilities on these countries defaulting on their debts.

The onset of the financial crisis in 2008 raised the CDS spreads for all of the sampled groups of countries, especially for those in Eastern Europe. At the time, it was believed that Eastern European countries relied heavily on foreign capital flows to roll over their debt obligations. The Russian default in the late 1990s had made investors wary of the ability of these countries to service their debts in the face of a global downturn. In fact, many of the countries on the list solicited emergency loans from the International Monetary Fund.

Since the crisis, it is clear that investors have become increasingly wary of the distressed eurozone countries. Their CDS spreads have continued to rise, reaching newer highs each quarter. These countries have relatively elevated debt levels, and investors have little faith in the countries' abilities to service their debt obligations. Although the CDS spread on these countries as a group was lower than that of their Eastern European peers initially, subsequent events have raised the spreads on the distressed countries' debt well beyond those for Eastern Europe.

Also notable is the fact that spreads on the nondistressed eurozone and Western European countries were initially elevated but then fell, reflecting that these countries were viewed after the crisis as fiscally sound. However, in the past few months, the fact that these spreads have continued to rise does not bode well for these countries in particular and the European region as a whole. More recently, although the spreads have receded from recent highs, investors' concerns about European debt continue to persist.